FOREX: Euro Looks to ECB Rate Decision for Much-Needed Lifeline

Talking Points

• All Eyes on European Central Bank Interest Rate Decision
• Euro Needs ECB Pledge to Support Sovereigns to Recover
• US Dollar Little Changed vs. Majors in Quiet Asian Trade

The US Dollar (ticker: USDollar) was little changed against the majors overnight as currency markets consolidated ahead of the upcoming European Central Bank interest rate decision. Traders are pricing in no chance of another interest rate cut according to data compiled by Credit Suisse, putting the spotlight on ECB President Mario Draghi’s press conference following the announcement. The crucial issue at hand will be the outcome of the bank’s 3-year long-term refinancing operation (LTRO).

Euro area banks borrowed €489.2 billion through the facility in December only to park the money back with the central bank. Indeed, the size of the ECB’s deposit facility topped €400 billion for the first time ever on the day following LTRO settlement and has continued to climb since, hitting a record €486 billion yesterday. The banks preference for paying the ECB 0.75 percent per year to store the cash (they are borrowing at 1 percent and earning 0.25 percent through the deposit facility) rather than re-lending it at a profit reflects their lack of confidence in the ability of Eurozone officials to quell the debt crisis. Indeed, if a Euro member state defaults, lenders will need a sizable war-chest to cover losses on their sovereign bond holdings as well as meet capital requirements amid increasingly dry credit markets.

As long as LTRO money sits on the sidelines, the stimulative boost the ECB hoped to achieve by funneling cheap credit into the economy is absent. With this in mind, traders will be keen to hear Mr Draghi explain how policymakers plan to remedy the situation. While it’s probably too soon to hope for additional measures considering the last 3-year operation occurred less than a month ago, a dose of confidence-building rhetoric to help relieve bankers’ anxieties is certainly a possibility. To have the desired effect, traders will need to hear the ECB at least allude to possible future steps to ramp up support for sovereign debt markets, assuring investors that a lender of last resort stands ready to prevent insolvency in member state too big to be bailed out via the existing EFSF rescue mechanism (like Italy or Spain, for example).

Such an outcome is likely to support risk appetite and boost the Euro as well as sentiment-linked currencies at the expense of the greenback. Alternatively, invoking the ECB’s limited mandate to lay the responsibility of restoring confidence at the feet of EU and governmental officials once again will probably produce the opposite effect considering markets have lost a good deal of trust in the ability of politicians to meaningfully help the situation after the long series of false starts already in the history books. On the issuance docket, Spain and Italy are due to sell bonds today, but the auctions’ market-moving is likely to be diminished as traders wait for the ECB announcement before making directional commitments. The Bank of England is likewise on tap to deliver a policy decision, with another non-event likely as Mervyn King and company wait for the current round of asset purchases to be completed this month before adding anything new into the mix.

Asia Session: What Happened

Euro Session: What to Expect

Critical Levels

--- Written by Ilya Spivak, Currency Strategist for Dailyfx.com

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